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an adequate return on capital in order to be worthwhile. The more capital that is employed the higher that return needs to be. Many activities can make sense when only a thin base of capital is required, but would not be entertained with a larger capital requirement.

One might argue for relying on an implicit or explicit government guarantee instead. Either approach seems mistaken, especially relying on an implicit guarantee. The markets have become quite wary of implicit government guarantees, since there is a fear that Congress might not authorize the funds necessary to make good on them or the Administration might find it necessary to alter the implicit guarantee, which is much easier since it has not been stated. As a result, financing for the nationalized bank would likely remain expensive, losing a major potential advantage of nationalization.

An explicit guarantee would be better, but it is worth noting that some bank debt is already being issued with explicit government guarantees. The interest rate on the debt is generally running tens of basis points higher than on direct government borrowing. (A basis point is onehundred of one percent.) This cost may seem small in relation to the total size of the rescue, but it is unclear what the policy benefit would be of following this approach, since an explicit guarantee means the taxpayer is on the hook just as much as if Treasury supplied the funds directly. Perhaps there would be a political benefit, although it is not clear currently what this would be. Importantly, the Emergency Economic Stabilization Act, which authorized the federal rescue efforts, counts each guarantee dollar for dollar against the cap on authorized activity, just as if it were the direct purchase of a bank’s securities. The effect on the federal budget is also essentially the same regardless of whether it is a loan or a guarantee of a loan.

It appears that there would only be two good reasons for choosing not to infuse the money directly. One would be because the government is not truly committed to keeping the bank adequately capitalized, which would be a mistake. The second would be because there was a political constraint on the amount of money directly put into the bank. This could end up being the case, but it would create needless interest expense and would make it more difficult to move to reprivatization.

Ironically, it might also be necessary to pay existing shareholders for their stock, as discussed under Step 1, if the government otherwise lacks the full legal basis to seize the bank as quickly as it would like. For example, it might not have sufficient evidence to force the assets to be marked all the way down to what it sees as the true market value, leaving the accounting value of the Tier 1 capital above the 2% leverage threshold.

This assumes that any existing preferred stocks, bonds, or other debt would be left in place. It may be considered desirable to pay off some highcost debt, if the contract terms allow, in which case still more funds would be needed. It may also be possible to write down the volume of debt; see Step 5 for a discussion as to whether to force debtholders to share in the cost of the rescue.


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